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Introduction to FIN 48

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					         Introduction to FIN 48:
Accounting for Uncertainty in Income Taxes

               ACCT 70053
               Spring 2008
                    Scope
• FIN 48 applies to “all tax positions accounted
  for in accordance with Statement 109.”
                 Tax positions
• Tax position refers to a position in a previously
  filed tax return or a position expected to be taken
  in a future tax return that is reflected in
  measuring current or deferred income tax assets
  and liabilities for interim or annual periods.
• A tax position can result in a permanent
  reduction of income taxes payable, a deferral of
  income taxes otherwise currently payable to
  future years, or a change in the expected
  realizability of deferred tax assets.
                Tax positions
The term tax position also encompasses, but is not
  limited to:
• A decision not to file a tax return
• An allocation or a shift of income between
  jurisdictions
• The characterization of income or a decision to
  exclude reporting taxable income in a tax return
• A decision to classify a transaction, entity, or
  other position in a tax return as tax exempt
                    Tax positions
When a position is taken in a tax return that reduces the
  amount of income taxes paid to a taxing authority, the
  enterprise realizes an immediate economic benefit.
• Considerable time can elapse before the acceptability of
  that tax position is determined.
• FIN 48 requires the affirmative evaluation that it is more
  likely than not, based on the technical merits of a tax
  position, that an enterprise is entitled to economic benefits
  resulting from positions taken in income tax returns.
• If a tax position does not meet the more-likely-than-not
  recognition threshold, the benefit of that position is not
  recognized in the financial statements.
              Tax positions
Examples:
• Company A deducts certain costs in
  computing taxable income. The relevant tax
  law is ambiguous and the deduction may be
  disallowed.
• Company B deducts certain costs in
  computing taxable income. The relevant tax
  law is ambiguous and the company may be
  required to capitalize the costs.
               Tax positions
In principle, the validity of a tax position is a
  matter of tax law.
• When the degree of confidence is high that
  that tax position will be sustained, it is not
  controversial to recognize the benefit of a tax
  position in an enterprise’s financial statements
• In some cases, the law is subject to varied
  interpretation, and whether a tax position will
  ultimately be sustained may be uncertain.
                   Recognition
An enterprise shall initially recognize the financial
  statement effects of a tax position when it is more
  likely than not, based on the technical merits, that the
  position will be sustained upon examination.
• The more-likely-than-not recognition threshold is a
  positive assertion that an enterprise believes it is
  entitled to the economic benefits associated with a tax
  position.
• The determination of whether or not a tax position has
  met the more-likely-than-not recognition threshold
  shall consider the facts, circumstances, and
  information available at the reporting date.
           More likely than not
In assessing the more-likely-than-not criterion:
a. It shall be presumed that the tax position will be
    examined by the relevant taxing authority that
    has full knowledge of all relevant information.
b. Technical merits of a tax position derive from
    sources of authorities in the tax law and their
    applicability to the facts and circumstances of
    the tax position.
c. Each tax position must be evaluated without
    consideration of the possibility of offset or
    aggregation with other positions.
               Measurement
A tax position that meets the more-likely-than-
  not recognition threshold shall initially and
  subsequently be measured as the largest
  amount of tax benefit that is greater than 50
  percent likely of being realized upon
  settlement with a taxing authority that has full
  knowledge of all relevant information.
        Measurement example
Company C has determined that a tax position
  resulting in a benefit of $100 qualifies for
  recognition and should be measured.
Management believes it is likely that it would
  settle for less than the full amount of the
  entire position when examined.
           Measurement example
 Possible estimated       Probability of         Cumulative
      outcome             occurring (%)        probability (%)
       $100                    25                     25
         75                    50                     75
         50                    25                    100


Because $75 is the largest amount of benefit that is greater than
50 percent likely of being realized upon settlement, Company C
would recognize a tax benefit in the financial statements in this
amount.
         Measurement example
Journal entries:
Income taxes payable                100
      Tax benefit                         100
To record tax benefit claimed on the tax return.
Tax benefit                          25
      Liability for unrecognized
         tax benefits                      25
To reduce tax benefit to the maximum amount
  allowed by FIN 48.
        Subsequent recognition and
              measurement
If the more-likely-than-not recognition threshold is not
    met in the period for which a tax position is taken or
    expected to be taken, an enterprise shall recognize the
    benefit of the tax position in the first interim period
    that meets any one of the following three conditions:
a. The more-likely-than-not recognition threshold is met
     by the reporting date.
b. The tax position is effectively settled through
     examination, negotiation, or litigation.
c. The statute of limitations for the relevant taxing
     authority to examine and challenge the tax position
     has expired
               Derecognition
An enterprise shall derecognize a previously
  recognized tax position in the first period in
  which it is no longer more likely than not that
  the tax position would be sustained upon
  examination.
                  Interest
When the tax law requires interest to be paid on
 an underpayment of income taxes, an
 enterprise shall begin recognizing interest
 expense in the first period the interest would
 begin accruing according to the provisions of
 the relevant tax law.
                 Interest
The amount of interest expense to be
recognized shall be computed by applying the
applicable statutory rate of interest to the
difference between the tax position
recognized in accordance with this
Interpretation and the amount previously
taken or expected to be taken in a tax return.
                  Penalties
Similarly, if the company would incur penalties if
  the uncertain tax position were not sustained,
  penalties must be accrued in the first period
  would give rise to the penalty.
                  Example 1
Company D has incurred $100 of costs, which have
  been deducted in full on its 2007 tax return and
  recognized as an expense for 2007. Management
  estimates there are three possible outcomes:
1) $100 will be allowed as a deduction in 2007
   (p=.40)
2) $50 will be allowed as a deduction in 2007 with
   the balance amortized over 5 years (p=.40)
3) The entire $100 must be amortized over 5 years
   (p=.20)
                  Example 1
In this example, the deductibility of the costs is
  not in question. It is simply a matter of when
  they will be deductible.

               2007    2008   2009    2010   2011
 (1) p=.40      100      0      0       0      0
 (2) p=.40       60     10     10      10     10
 (3) p=.20       20     20     20      20     20
                    Example 1
Assume a 40% tax rate. Thus, the tax benefit of
  this item for 2007 could be:
            Scenario          Tax benefit
            (1) p=.40      $100 @ 40% = $40
            (2) p=.40      $ 60 @ 40% = $24
            (3) p=.20      $ 20 @ 40% = $ 8

The largest amount that is more than 50% likely
is $24 (scenario 2). Therefore, Company D would
recognize a tax benefit of $24.
                 Example 1
If scenario (2) occurs, Company C will have a
   temporary difference:
Tax basis of asset                      $ 40
Book basis of asset                        0
  Future deductible amount              $ 40
Tax rate                                  40%
Deferred tax asset                      $ 16
                  Example 1
Journal entries:
Income tax payable                       40
      Tax benefit                               40
(To record tax benefit claimed on 2007 tax return)
Deferred tax asset                       16
      Liability for unrecognized tax
        benefits                                16
(To recognize DTA required by FIN 48)
                 Example 2
Company E acquired an intangible asset for $30.
  The asset has an indefinite life and, therefore,
  is not subject to amortization.
For tax purposes, Company E decides to deduct
  the full cost in 2007 even though the tax law is
  ambiguous on this point.
Assume a 40% tax rate applies.
                 Example 2
Management estimates that there are three
  possible outcomes:
1) $30 will be allowed as a deduction in 2007
   (p=.30)
2) The asset must be amortized straight-line
   over 3 years (p=.30)
3) The cost of the asset is not deductible in any
   period (p=.40)
                 Example 2

The possible patterns of deductions are as
follows:
                2007         2008        2009
(1) p=.30        30           0              0
(2) p=.30        10           10             10
(3) p=.40         0           0              0
                      Example 2
The possible amounts of tax benefit for 2007 are
as follows:
          Scenario           Tax benefit
          (1) p=.30        $30 @ 40% = $12
          (2) p=.30        $10 @ 40% = $ 4
          (3) p=.40               0

The largest amount that is more than 50%
likely is $4 (scenario 2). Therefore, Company E
would recognize a tax benefit of $ 4.
                  Example 2
If scenario (2) occurs, Company D will have a
temporary difference:

Tax basis of asset                     $ 20
Book basis of asset                      30
 Future taxable amount                 $ 10
Tax rate                                 40%
Deferred tax liability                 $ 4
                  Example 2
Journal entries:
Income taxes payable                       12
      Tax benefit                               12
(To record tax benefit claimed on 2007 tax return)
Tax benefit                                 8
      Deferred tax liability                     4
      Liability for unrecognized tax benefits    4
(To adjust tax benefit to maximum allowed under
  FIN 48)
                 Example 2a
Suppose that in 2008, a court case resolves the
  uncertainty regarding this type of asset: the
  court finds that it is not deductible in any year.
The tax position recognized in 2007 must be
  derecognized in 2008.
                Example 2a
Journal entry:
Tax benefit                            4
Deferred tax liability                 4
Liability for unrecognized tax
 benefits                              4
       Income taxes payable                 12
(To derecognize tax position taken in 2007)
                     Disclosures
Companies are required to provide a reconciliation of the
  beginning and ending amount of unrecognized tax benefits.
  This one is from Merck’s 2007 annual report:

2007                                          ($millions)
Balance as of January 1                        $ 5,008.4
Additions related to prior year positions          187.8
Reductions for tax positions of prior years         (87.0)
Additions related to current year positions        284.5
Settlements                                     (1,703.5)
Lapse of statute of limitations                      (0.7)
Balance as of December 31                      $ 3,689.5
           Required disclosures
a. A tabular reconciliation of the total amounts of
   unrecognized tax benefits at the beginning and
   end of the period
b. The total amount of unrecognized tax benefits
   that, if recognized, would affect the effective tax
   rate
c. The total amounts of interest and penalties
   recognized in the statement of operations and
   the total amounts of interest and penalties
   recognized in the statement of financial position
            Required disclosures
d. For positions for which it is reasonably possible
   that the total amounts of unrecognized tax
   benefits will significantly increase or decrease
   within 12 months of the reporting date:
   1) The nature of the uncertainty
   2) The nature of the event that could occur in the next
      12 months that would cause the change
   3) An estimate of the range of the reasonably possible
      change or a statement that an estimate of the range
      cannot be made
e. A description of tax years that remain subject to
   examination by major tax jurisdictions.

				
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